4 - Ethical Practices

Question 1

What is a material fact?

Answer 1

Information used by a prospective purchaser to make an informed investment decision.

Question 2

What are the three criteria the Uniform Securities Act uses to define fraudulent and other prohibited practices?

Answer 2

1. Employing any device, scheme or artifice to defraud;
2. Making any untrue statement of a material fact or omitting to state a material fact necessary to make a statement not misleading; or
3. Engaging in any act, practice, or course of business that operates as a fraud or deceit on a person.

Question 3

What are the criteria the Uniform Securities Act uses to define fraudulent and other prohibited practices for investment advisers or investment adviser representatives?

Answer 3

1. Employing any device, scheme or artifice to defraud the other person; or
2. Engaging in any act, practice or course of business which operates or would operate as a fraud or deceit upon the other person.

Question 4

Describe the breadth of the antifraud provisions of state securities laws.

Answer 4

These provisions are very broad. They cover any person or transaction involving a security, regardless of whether the person, security or transaction is registered, exempt or federal covered.

Question 5

May registered agents share fees or split commissions?

Answer 5

Yes, but only if they are registered as agents for the same broker-dealer or two broker-dealers under common ownership or control. Clients need not be told of such arrangement so long as it does not increase the amount of commission charged.

Question 6

May an individual register as an agent for more than one broker-dealer?

Answer 6

An agent may only registered with multiple broker-dealers if the firms are affiliated by direct or indirect common control. For example, an agent may register with two broker-dealers that are owned by the same parent company. An agent cannot register with two unrelated firms.

Question 7

What are some examples of material facts that would constitute fraud if misstated by agents or broker-dealers knowingly and willfully?

Answer 7

1. inaccurate market quotations;
2. misstatements of an issuer’s earnings, projected earnings or dividends;
3. inaccurate statements regarding the amount of commissions, markups or markdowns;
4. stating or implying that the agent has inside information when he does not;
5. telling a customer that a security will be listed on an exchange without reliable information;
6. informing a client that registration of a security means approval by the SEC or Administrator of such security, or that the Administrator or SEC approves of the agent or broker dealer;
7. misrepresenting the status of customer accounts;
8. promising a client services without the intent or ability to perform them.

Question 8

Can brokerage commissions or markups ever be higher than normal?

Answer 8

Yes, provided it is disclosed to the client.

Question 9

What are a broker’s disclosure obligations with respect to his or her commissions?

Answer 9

Unless a commission is higher than normal, a broker-dealer is not required to disclose the amount of the commission on an offer to sell before the transaction. The amount of the commission is always required to be disclosed on the trade confirmation.

Question 10

An agent or adviser tells a client that he has inside information when he does not. Is this fraud?

Answer 10

Yes. An agent that states or implies that he has inside information when he does not has acted fraudulently.

Question 11

What is the difference between telling a client that a security is registered with a state Administrator and telling a client that a security is approved by a state Administrator?

Answer 11

Saying that a security is “registered” is permissible; saying that a security is “approved” constitutes fraud.

Question 12

What is SIPC?

Answer 12

SIPC (Securities Investor Protection Corporation) protects clients of broker-dealers in the event of a broker-dealer bankruptcy by appointing a trustee to return client assets.

Question 13

What information must be included in an order ticket?

Answer 13

The account ID, a description of the security (including the number of shares or par value), the terms and conditions of the order, the time of order entry and execution, the execution price and the identity of the agent. The client’s name and address need not be included on the order ticket.

Question 14

What is the definition of material inside information?

Answer 14

Any information about a company that has not been released to the public and that would likely affect the value of a security.

Question 15

Are there any exemptions from the anti-fraud provisions of the Uniform Securities act?

Answer 15

No. There are no exemptions from the Uniform Securities Act’s anti-fraud provisions.

Question 16

What should an agent or investment adviser representative do if he comes into possession of material inside information?

Answer 16

Immediately report the possession of the information to a supervisor or compliance officer. The agent or investment adviser representative may not make recommendations based on the inside information, even if acquired accidentally.

Question 17

Can an agent or investment adviser representative use information from a broker-dealer or investment adviser’s research report if the report has not been made public?

Answer 17

Yes, this is not considered inside information.

Question 18

When does an insider information violation occur?

Answer 18

Only when the information is used for trading. Possession alone or even giving someone the information, if it is not used, is not in itself a violation.

Question 19

What are the repercussions for engaging in practices that are considered dishonest and unethical business practices under the Uniform Securities Act?

Answer 19

Engaging in such prohibited actions can result in denial, suspension or revocation of registration, a fine, or in the case of fraudulent practices, imprisonment.

Question 20

What is churning?

Answer 20

Inducing trading in a customer’s account which is excessive in size or frequency in view of the financial resources, objectives and character of the account. It is prohibited under the Uniform Securities Act.

Question 21

What constitutes unethical delivery delays by a broker-dealer?

Answer 21

A pattern of unreasonable and unjustifiable delays in the delivery of securities and/or in the payment upon request of free credit balances to its customers.

Question 22

What kinds of recommendations by an agent or broker-dealer are considered unethical?

Answer 22

Recommendations about a security transaction without reasonable grounds to believe that such recommendation is suitable for the customer, based on reasonable inquiry concerning the customer’s investment objectives, financial situation and needs, and any other relevant information known by the broker-dealer or agent.

Question 23

What kinds of recommendations may an agent or broker-dealer make to a client who refuses to discuss investment objectives?

Answer 23

The agent may not make any recommendations without reasonable grounds to believe that such recommendation is suitable, but may accept unsolicited orders from the client.

Question 24

Who can imply that securities are approved by a state securities administrator?

Answer 24

No one can ever imply that securities are approved by the Administration, to do so is fraud. The Administrator does not approve or disapprove of securities. State securities administrators clear securities for public distribution.

Question 25

What are blanket recommendations? Are they ever ethical?

Answer 25

An agent makes a blanket recommendation when he recommends the same security or transaction to a majority of his clients. It is unethical behavior because it does not take into account each client’s unique financial needs.

Question 26

When is it permissible for agent to accept instructions from a party other than his client?

Answer 26

The agent must have a written third-party trading authorization on file.

Question 27

When may an agent exercise discretion in effecting a transaction for his customer’s account?

Answer 27

An agent must have written authority to use his own discretion in making investment decisions for the client regarding selection of securities, whether to buy or sell and the number of shares. Decisions relating solely to time and price are not considered discretion. Discretionary trades must be suitable for the customer. The agent must obtain the written authorization prior to the first discretionary trade.

Question 28

When must an agent obtain a written margin agreement from a client?

Answer 28

The agent must obtain a properly executed written margin agreement from his client promptly after the initial transaction in the margin account.

Question 29

What are the rules regarding commingling of customer and firm assets?

Answer 29

Securities held in a client’s name must not be commingled - held in the same account - with securities of the firm.

Question 30

What are matched purchases?

Answer 30

Matched purchases are a prohibited form of market manipulation. They occur when investors collude to buy and sell securities among themselves, creating a false impression of activity in the security, thus driving up prices and allowing them to sell at a profit.

Question 31

What is a wash trade?

Answer 31

Wash trades are a prohibited form of market manipulation. They occur when an investor simultaneously buys and sells in different brokerage accounts, creating a false impression of activity in the security and driving up prices.

Question 32

Who is exempt from the anti-fraud provisions of the Uniform Securities Act?

Answer 32

No one is ever exempt from the anti-fraud provisions of the Uniform Securities Act.

Question 33

What is arbitrage?

Answer 33

Arbitrage is the simultaneous buying and selling of the same security in different markets. Arbitrage is not considered market manipulation, and it is not prohibited under the Uniform Securities Act.

Question 34

What are the Uniform Securities Act rules regarding guaranteed securities?

Answer 34

Securities professionals may not guarantee the performance of securities, nor may they guarantee against loss by providing funds to a client account. However, it is allowable to refer to a guaranteed security when an entity other than the issuer is making the guarantee.

Question 35

When can an individual imply that securities have been approved by the Administrator or the SEC?

Answer 35

Never. Individuals may never imply that securities have been approved by a state securities administration or the SEC. This is fraudulent.

Question 36

Describe deceptive advertising practices as prohibited under the Uniform Securities Act.

Answer 36

Any advertising or sales presentation that is deceptive or misleading is prohibited, including using nonfactual data (like charts of graphs) based on conjecture or unrealistic claims to detract from or defeat the purpose of information given in a prospectus or disclosure, leaving out information about risk factors or deal killers, or highlighting positive information while minimizing negatives.

Question 37

What are the Uniform Securities Act rules regarding broker-dealer and agent disclosures of conflicts of interest?

Answer 37

An agent or broker-dealer must disclose that the broker-dealer is controlled by, controlling, affiliated with or under common control with the issuer of any security before entering into a contract with or for a customer for the purchase or sale of such security. An agent must also disclose any other conflicts of interest, such as the fact that his spouse is a control person at such issuer. The disclosure must be made in writing, or if made orally must be supplemented with a written disclosure no later than the completion of the transaction.

Question 38

What does the Uniform Securities Act require an agent to do upon receipt of a written customer complaint?

Answer 38

The agent must immediately report the complaint to his supervisor.

Question 39

What does the Uniform Securities Act require an agent or broker-dealer to do upon receipt of an oral customer complaint?

Answer 39

Nothing; the Uniform Securities Act only requires that action be taken in response to a written customer complaint.

Question 40

What does the Uniform Securities Act require a broker-dealer to do upon receipt of a written customer complaint?

Answer 40

The firm must notify the complainant that the complaint was received and make an appropriate entry in the firm’s complaint file. If an agent were the subject of the complaint, the agent must be notified but does not receive a copy of the complaint.

Question 41

What does the Uniform Securities Act require a broker-dealer to do if a complaining client withdraws its complaint?

Answer 41

The firm must return the original written complaint to the customer and keep a copy in its complaint file.

Question 42

What is front running?

Answer 42

Front running occurs when a broker-dealer or agent places its own personal order ahead of a previously received customer order. It is fraudulent under the Uniform Securities Act.

Question 43

What are the Uniform Securities Act rules regarding the backdating of securities transaction records?

Answer 43

Backdating records and documents is never permitted, despite potential tax benefits to clients.

Question 44

Are clients permitted to waive their rights under the Uniform Securities Act?

Answer 44

No. Any such waiver is null and void.

Question 45

In connection with the solicitation of investment company shares, what must an agent or broker-dealer disclose to clients regarding sales charges?

Answer 45

1. If there is a front-end load, a contingent deferred sales load, or a Rule 12b-1 fee or service fee in excess of 0.25% of average net fund assets per year;
2. whether there are sales charge discounts on the purchase of shares in dollar amounts at or above a breakpoint; and
3. whether there is a letter of intent feature that will reduce sales charges.

Question 46

Are broker-dealers or investment advisers permitted to lend money to clients?

Answer 46

No, unless the broker-dealer or investment adviser is a financial institution engaged in the business of loaning funds, or the client is an affiliate.

Question 47

Are agents and investment advisers permitted to borrow money from clients?

Answer 47

No, unless the client is a broker-dealer, an affiliate or a financial institution in the business of loaning money.

Question 48

What is “selling away”? Is it ethical?

Answer 48

Selling away, or trading off the books, occurs when an agent effects securities transactions not recorded on the books or records of the broker dealer. It is prohibited under the Uniform Securities Act unless the broker-dealer has previously authorized the transaction in writing.

Question 49

Are agents permitted to share in their clients’ accounts?

Answer 49

Agents are permitted to share in the profits and losses of client accounts with the written authorization of the client and the broker-dealer.

Question 50

Are investment adviser representatives permitted to share in their clients’ accounts?

Answer 50

Investment adviser representatives (and broker dealers and investment advisers) are never permitted to share in client accounts.

Question 51

Are testimonials on advertising literature, sales brochures or websites permissible for agents, broker-dealers, investment advisers and investment adviser representatives?

Answer 51

Testimonials are permitted for broker-dealers and agents, but not for investment advisers and investment adviser representatives.

Question 52

When may an investment adviser disclose information about a client’s identity or investments?

Answer 52

Only to other parties of a joint account, if required by law, or if otherwise consented to by the client.

Question 53

What are the Uniform Securities Act rules regarding investment advisers engaging in principal or agency transactions?

Answer 53

Written client consent is required either prior to execution of the principal or agency transaction, or (together with sufficient information to inform the client of the adviser’s conflicts of interest) after execution but prior to settlement.

Question 54

What are the Uniform Securities Act rules regarding agents and broker-dealers engaging in principal or agency transactions?

Answer 54

No client consent is required, but the broker-dealer must indicate its capacity as principal or agent on the trade confirmation.

Question 55

What is an agency cross transaction?

Answer 55

An agency cross transaction occurs when an investment adviser executes a trade between two of its clients.

Question 56

What is required of an investment adviser executing an agency cross transaction?

Answer 56

An investment adviser must obtain the written consent of both customers prior to executing an agency cross transaction. Note: an investment adviser is prohibited from soliciting both sides of the trade. One of the clients must enter the order on an unsolicited basis.

Question 57

When must an investment adviser disclose whether it is acting as a broker or a dealer when executing a trade for a customer?

Answer 57

An investment adviser must disclose whether it is acting as a broker or a dealer before entering the trade. This is different than the requirement for broker-dealers, which can disclose their capacity after entering the trade on the trade confirmation.

Question 58

When must an broker-dealer disclose whether it is acting as a broker or a dealer when executing a trade for a customer?

Answer 58

A broker-dealer must disclose its capacity - whether it is acting as a broker or a dealer - after entering the trade on the trade confirmation. This is different than the requirement for an investment adviser, which must disclose its capacity before entering the trade.

Question 59

When can a investment adviser act outside its clients best interest?

Answer 59

Never, investment advisers, and investment adviser representatives, have a fiduciary duty to their clients and must always act in their client’s best interest.

Question 60

What are the registration implications for a broker-dealer that charges its clients a wrap fee?

Answer 60

A broker-dealer that charges a wrap fee must register as an investment adviser if it provides its clients any investment advice.

Question 61

Under what circumstances must a Currency Transaction Report be filed?

Answer 61

The Bank Secrecy Act requires every financial institution to file a Currency Transaction Report for all cash transactions exceeding $10,000.

Question 62

How is a cash transaction defined for purposes of determining if a Currency Transaction Report must be filed?

Answer 62

For purposes of a CTR, cash includes money, cashier’s checks or traveler’s checks deposit by a client totaling more than $10,000 in one day.

Question 63

Under what circumstances can an investment adviser or broker-dealer advertise statistical devices or analysis for portfolio recommendations?

Answer 63

Only if it also discloses the limitations for the particular models or systems being advertised.